Debt Financing Essay

4203 words - 17 pages

111008 – Research in Business and Economics Journal

Determinants of short-term debt financing
Richard H. Fosberg William Paterson University ABSTRACT In this study, it is shown that both theories put forward to explain the amount of shortterm debt financing that a firm employs have validity. The matching principle correctly predicts that the amount of short-term debt financing that a firm uses is directly related to the quantity of the firm’s current assets. Additionally, other factors that have been shown to affect the levels of long-term debt financing that a firm employs are also shown to affect the amount of short-term debt financing that a firm uses. Specifically, the amount of firm ...view middle of the document...

These factors include firm size, profitability and market-to-book ratio. The purpose of this study is to determine whether the matching principle fully explains the amount of short-term debt financing that a firm employs or if factors that affect the amount of long-term debt financing that a firm uses also affect the amount of short-term debt financing that a firm employs. SHORT-TERM DEBT THEORY According to the matching principle of finance, short-term assets should be financed with short-term liabilities and long-term assets should be financed with long-term liabilities (Guin (2011)). Short-term assets and liabilities are generally defined to be those items that will be used, liquidated, mature or paid off within one year (Guin (2011)). A firm’s current assets (including cash, inventories, accounts receivable, etc.) are generally considered short-term assets while plant and equipment are generally considered long-term assets. Nevertheless, current assets can be long-term if they are not completely used or liquidated during the year. For example, suppose a firm’s raw materials inventory is used and replenished periodically so that the level of inventory varies between $600 and $900 during the year. The minimum level of raw materials inventory ($600) is effectively a long-term inventory investment as the inventory level never drops below this amount. The difference between the maximum and minimum values ($300) is a temporary inventory investment that is liquidated at some point during the year. On the other side of the balance sheet, current liabilities (accounts payable, short-term debt, etc.) are usually considered short-term liabilities while long-term debt (debt with a maturity of more than one year) and equity capital are considered long-term liabilities. However, current liabilities can be a source of long-term financing if they are not completely paid off during the year. For example, assume a firm periodically receives and pays off short-term loans in such a way that the firm’s short-term loan balance varies between $300 and $500 during the year. The $300 minimum loan balance is effectively a long-term source of financing while the difference between the maximum and minimum loan balances ($200) is short-term financing that is paid off during the year. Notwithstanding the above, if it is assumed that a firm’s current assets (CA) and current liabilities (CL) are short-term assets and short-term financing, respectively, the matching principle implies that a firm’s current assets should equal its current liabilities. Next, define spontaneous current liabilities to be liabilities whose values change during the year without any explicit action by the firm’s managers. For example, when a firm grows it generally purchases more goods and services from its suppliers resulting in a spontaneous increase in accounts payable. Assuming current liabilities, other than short-term debt, are relatively spontaneous

637 words - 3 pages
basis does P&G use to report its investments? How much working capital did P&G have on June 30, 2007? On June 30, 2006? (d) What were P&G's cash flows from its operating, investing, and financing activities for 2007? What were its trends in net cash provided by operating activities over the period 2005 to 2007? Explain why the change in accounts payable and in accrued and other liabilities is added to net income to arrive at net cash provided by

3071 words - 13 pages
is no exact equation to figure out the exact cost of bankruptcy.
Due to the lack of a definite cost of bankruptcy, we must weight all the different capital structure options that we have at our fingertips. Equity and debt financing each come with their own advantages and disadvantages, so every company will weigh these benefits and costs differently and formulate a capital structure they are most comfortable with, and ultimately maximize

276 words - 2 pages
Long-Term Financing Paper
For a publicly traded company, shareholder value is the part of its capitalization that is equity as opposed to long-term debt. In the case of only one type of stock, this would roughly be the number of outstanding shares times current share price. Things like dividends augment shareholder value while issuing of shares (stock options) lower it. This Shareholder value added should be compared to average/required

1543 words - 7 pages
common stock as expected, followed by debt financing. During this stage, MCI had grossly under-estimated its cash requirements to support its build-out strategy which had led to the technical default. This had forced the firm to raise equity financing in an emergency mode, allowing it to survive.
During the growth stage (triggered by the success of Execunet), the need to obtain funds to support operations and capital investment dominated the firm’s

1415 words - 6 pages
)
Estimate the cost of capital for financing
The cost of debt is the effective rate that a company pays on its total debt. As a company acquires debt through various bonds, loans and other forms of debt, the cost of debt is a useful metric. It gives an idea as to the overall rate being paid by the company to use debt financing. This measure is also useful because it gives investors an idea as to the riskiness of the company compared with others

6464 words - 26 pages
$ 49,875
c. The alternative financing plan which calls for more financing by high-cost debt is more expensive and reduces aftertax income by $14,000. However, we must not automatically reject this plan because of its higher cost since it has less risk. The alternative provides the firm with long-term capital which at times will be in excess of its needs and invested in marketable securities. It will not be forced to pay higher short

437 words - 2 pages
opposed to equity?
Advantages -Provides a tax shield, Is not dilutive from an ownership standpoint. Better for short-term financing. Issuing debt may be a signal for the company's strength because managers are confident that they won't go into bankruptcy and don't want to dilute existing shares. It can also signal a commitment to increase output to rival firms.
Disadvantages - Increases the company's risk level. Company is more sensitive to

Similar Documents

445 words - 2 pages
they should use the APV approach to value the project. Because it is more convenient to value to firm when level of debt has no relationship with the firm's value. APV gives the financial manager an explicit view of the financial side effect such as interest tax shield (the most important), cost of securities and financing subsidized that are adding or subtracting the value.
APV
Assume that financing doesn't matter. APV is recommended to use

423 words - 2 pages
company has more financing from debt than from the equity. Creditors will not feel easy in this situation as increase in debt financing also increases their risk factor. On one hand debt has increased while on the other hand the companies ability to pay interest has decreased. Company is sailing in dangerous waters as it is too much dependent on debt financing. The profitabilty ratios has also decreased. Profit margin on sales , return on total asset